This week we sat down with Eline Murat, our Legal Officer to take a look at “second round financing” and what it actually entails for investors and entrepreneurs.
Some of you might wonder why we decided to focus our attention this week on the second and not the first round. That's why we’ll start by distinguishing the two phases, allowing us to highlight and examine the key difference between first and second rounds:
1. The first round: like every seed or early stage company with little or no revenue, an entrepreneur needs to find funds to start a business. Whether it’s with the help of family, friends, business angels or VC funds; this is a critical phase for entrepreneurs because it enables them to make their dream a reality.
2. The second round: launching a business isn’t an exact science. That’s why after a few months or sometimes years, start-ups always end up raising funds for a second round in order to develop their business even further, maintain their activity or sometimes save their company. This round is the trickiest one for entrepreneurs.
In order to understand the different scenarios which can occur during a second round, we first have to understand an important process that precedes each financing round: defining the company’s pre-money valuation. During this process the current worth of a company is examined by looking at the prospect of future earnings and market value of assets. This value also determines the value of the investor's share in the company and can sometimes drastically change between rounds, from better to worse or vice versa, and consequently affect people’s decision to invest, or to reinvest.
Based on these variables, here are three different second round scenarios:
The best case scenario: the company is booming and is in need of an investment in order to pursue its growth. In most cases, and thanks to the rising valuation, the historical investors reinvest and new investors are often attracted and decide to join the adventure.
The basic scenario: the company has relatively well performed, despite its ups and downs, and is looking for funds to further its development. In most cases, the historical investors and the Venture Capital funds easily reinvest, even if the valuation hasn’t risen. However, if a large amount is needed during the fundraising round, the need for new investors is crucial and by bringing in new shareholders in the company, the risk arises of them challenging the valuation and the investment conditions.
The worst case scenario: the company hasn’t succeeded and the existing shareholders are feeling let down. In this scenario it is particularly difficult for entrepreneurs to motivate historical investors to reinvest especially because the valuation has dropped. If newcomers decide to invest and believe enough in the company, they will, in many cases, ask for some guarantees such as a liquidation preference (allowing to be paid first in case of an exit or solvent liquidation).
The question of dilution and why is it important for investors to participate in the second round
As a historical investor, having invested in the previous round, the law offers you a preferential right. This right affords the priority to reinvest in the next capital increase. The preferential right is an opportunity but not an obligation for historical investors. You are therefore not obligated to exercise it. However it should be noted that should you choose to not take advantage of this right, the newly attracted investors will automatically affect your shareholder percentage. Indeed, your shareholder ownership percentage will decrease and you will be diluted.
Suppose a company issues 100 shares to 100 individual shareholders. Each shareholder owns 1% of the company. If the company then plans a second round and issues 100 new shares to 100 different shareholders, each of the 200 shareholders then own 0.5% of the company. The historical shareholders were therefore diluted.
On the other hand, if the historical shareholders decide to re-invest in the following capital increase and exercise their preferential right by subscribing to new shares; they will be able to keep their initial ownership percentage and avoid dilution.
Cautious investors will avoid putting most of their money in the first round, and rightly so. However, in order to avoid the effects of dilution on your shares, the key would be to reinvest so that you don't end up with a smaller share of the company.
To conclude, all start-ups necessarily have to go through a second (sometimes third or even fourth) round of financing, whether they are in good shape or not. As in most second rounds, the arrival of new investors causes the dilution of the existing shares and often changes in shareholder conditions can occur. That’s why at Spreds, we stay in contact with the companies that have raised funds via our platform in order to stay informed on what is going on and to be able to always offer investors the possibility to reinvest at the same conditions as the newcomers. Should there be substantial changes to the investment conditions, Spreds will give the historical investors the chance to vote on this change in conditions during a general assembly of Noteholders.